UNDERSTANDING OPEN MARKET OPERATIONS docx

Regardless of the particular approach, imple-menting monetary policy involves adjustments in the supply of bank reserves, relative to the reserve demand, in order to achieve and maintain

The Federal Reserve Bank of New York is responsible for

day-to-day implementation of the nation’s monetary

pol-icy It is primarily through open market

operations—pur-chases or sales of U.S Government securities in the

open market in order to add or drain reserves from the

banking system—that the Federal Reserve influences

money and financial market conditions that, in turn,

affect output, jobs and prices

This edition of Understanding Open Market

Operationsseeks to explain the challenges in

formulat-ing and implementformulat-ing U.S monetary policy in today’s

highly competitive financial environment The book

high-lights the broad and complex set of considerations that

are involved in daily decisions for open market

opera-tions and details the steps taken to implement policy

Michael Akbar Akhtar, vice president of theFederal Reserve Bank of New York, leads the reader—whether a student, market professional or an interestedmember of the public—through various facets of mone-tary policy decision-making, and offers a general per-spective on the transmission of policy effects throughoutthe economy

Understanding Open Market Operationsvides a nontechnical review of how monetary policy isformulated and executed Ideally, it will stimulate read-ers to learn more about the subject as well as enhanceappreciation of the challenges and uncertainties con-fronting monetary policymakers

Much has changed in U.S financial markets and

institu-tions since 1985, when the last edition of Open Market

Operations,written by Paul Meek, was published The

formulation and implementation of monetary policy also

have undergone some noteworthy changes over the

years Consequently, the current edition is a

substantial-ly new book rather than simpsubstantial-ly an update of the earlier

work Even so, I have made considerable use of

materi-als from Paul Meek’s book and have followed its

struc-ture where possible

I owe a special debt of gratitude to the Open

Market Desk staff at the Federal Reserve Bank of New

York: to Peter Fisher for allowing me to observe the daily

operations over an extended period of time; to Spence

Hilton, Sandy Krieger, Ann-Marie Meulendyke and John

Partlan for extensive comments on drafts; and to all ofthe Desk staff for graciously and patiently answering myquestions

Many other colleagues at the New York Fed alsomade significant contributions to this book’s publication,including Peter Bakstansky, Robin Bensignor, Scott Klass,Steve Malin, Carol Perlmutter, Ed Steinberg, CharlesSteindel and Betsy White, as well as Martina Heyd andEileen Spinner, who provided much of the data assis-tance, and Elisa Ambroselli, who typed numerous ver-sions of the manuscript; David Lindsey and VincentReinhart of the Board of Governors also made many use-ful suggestions I am greatly indebted to them all

As the nation’s central bank, the Federal Reserve System

is responsible for formulating and implementing

mone-tary policy The formulation of monemone-tary policy involves

developing a plan aimed at pursuing the goals of stable

prices, full employment and, more generally, a stable

financial environment for the economy In implementing

that plan, the Federal Reserve uses the tools of monetary

policy to induce changes in interest rates, and the

amount of money and credit in the economy Through

these financial variables, monetary policy actions

influ-ence, albeit with considerable time lags, the levels of

spending, output, employment and prices

The formulation of monetary policy has

under-gone significant shifts over the years In the early 1980s,

for example, the Federal Reserve placed special

empha-sis on objectives for the monetary aggregates as policy

guides for indicating the state of the economy and for

stabilizing the price level Since that time, however,

ongoing and far-reaching changes in the financial system

have reduced the usefulness of the monetary aggregates

as policy guides As a consequence, monetary policy

plans must be based on a much broader array of tors Today, the monetary aggregates still play a usefulrole in judging the appropriateness of financial conditionsand in making monetary policy plans, but their role isquite similar to that of many other financial and nonfinan-cial indicators of the economy

indica-To a considerable extent, changes in policy mulation have been accompanied by correspondingchanges in the implementation approach In the early1980s, monetary policy was implemented by targeting aquantity of bank reserves that was based on numericalobjectives for the monetary aggregates As the FederalReserve reduced its reliance on the monetary aggre-gates and conditioned its policy decisions on a widerange of indicators, the implementation strategy shiftedtoward a focus on reserve and money market conditionsconsistent with broader policy goals, rather than onachieving a particular quantity of reserves

for-No one approach to implementing monetarypolicy can be expected to prove satisfactory under alleconomic and financial circumstances The actual

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Introduction

approach has been adapted from time to time in light of

different considerations, such as the need to combat

inflation and the desire to deal with uncertainties

stem-ming from structural changes in the financial system

Thus, it is fair to say that the current implementation

approach is likely to continue to evolve in response to

changing circumstances

Regardless of the particular approach,

imple-menting monetary policy involves adjustments in the

supply of bank reserves, relative to the reserve demand,

in order to achieve and maintain desired money and

financial market conditions Among the policy

instru-ments used by the Federal Reserve, none is more

impor-tant for adjusting bank reserves than open market

oper-ations, which add or drain reserves through purchases orsales of securities in the open market Indeed, open mar-ket operations are, by far, the most powerful and flexibletool of monetary policy

Focusing on open market operations, this bookoffers a detailed description of how monetary policy isimplemented By tracing the economic and financial con-ditions that influence the actual decision-makingprocess, it attempts to provide a sense of the uncertain-ties and challenges involved in conducting day-to-dayoperations The book also reviews the monetary policyformulation process, and offers a broad perspective onthe linkages between monetary policy and the economy

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Policy Formulation

The basic link between monetary policy and the

econo-my is through the market for bank reserves, more

com-monly known as the federal funds market In that market,

banks and other depository institutions trade their

non-interest-bearing reserve balances held at the Federal

Reserve with each other, usually on an overnight basis

On any given day, depository institutions that are below

their desired reserve positions borrow from others that

are above their desired reserve positions The

bench-mark interest rate charged for the short-term use of

these funds is called the federal funds rate The Federal

Reserve’s monetary policy actions have an immediate

effect on the supply of or demand for reserves and the

federal funds rate, initiating a chain of reactions that

transmit the policy effects to the rest of the economy

The Federal Reserve can change reserves

mar-ket conditions by using three main instruments: reserve

requirements, the discount rate and open market

opera-tions The Board of Governors of the Federal Reserve

System (hereafter frequently referred to as the Board)

sets reserve requirements, under which depository tutions must hold a fraction of their deposits as reserves

insti-At present, as described in the next chapter, thesereserve requirements apply only to checkable or transac-tions deposits, which include demand deposits andinterest-bearing accounts that offer unlimited checkingprivileges Directors of the Reserve Banks set the dis-count rate and initiate changes in it, subject to reviewand determination by the Board of Governors TheReserve Banks administer discount window lending todepository institutions, making short-term loans

The Federal Open Market Committee (FOMC)directs the primary and, by far, the most flexible andactively used instrument of monetary policy—open mar-ket operations—to effect changes in reserves TheChairman of the Board of Governors presides overFOMC meetings, currently eight per year, in which theChairman, the six other governors, and the 12 ReserveBank presidents assess the economic outlook and planmonetary policy actions The voting members of theFOMC include the seven members of the Board of

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Monetary Policy and the Economy

Governors, the president of the Federal Reserve Bank of

New York—designated, by tradition, as the vice

chair-man of the FOMC—and four other Reserve Bank

presi-dents who serve in annual rotation There is sometimes

discussion as well at the FOMC meetings of reserve

requirements and the discount rate, although these tools

are outside the FOMC’s jurisdiction

Under the Federal Reserve Act as amended by

the Full Employment and Balanced Growth Act

of 1978 (the Humphrey-Hawkins Act), the

Federal Reserve and the FOMC are

charged with the job of seeking “to

pro-mote effectively the goals of maximum

employment, stable prices, and moderate

long-term interest rates.” The

Humphrey-Hawkins Act requires that, in the pursuit of

these goals, the Federal Reserve and the

FOMC establish annual objectives for

growth in money and credit, taking

account of past and prospective economic

develop-ments This provision of the Act assumes that the

econ-omy and the growth of money and credit have a

reason-ably stable relationship that can be exploited toward

achieving policy goals The law recognizes, however, that

changing economic conditions may necessitate revisions

to, or deviations from, monetary growth plans

Since about 1980, far-reaching changes in the

financial system have caused considerable instability in

the relationship of money and credit to the economy Inparticular, monetary velocities—ratios of nominal GDP(gross domestic product) to various monetary aggre-gates—have shown frequent and marked departuresfrom their historical patterns, making the monetaryaggregates unreliable as indicators of economic activityand as guides for stabilizing prices Velocities of M1 (cur-rency, checkable deposits and travelers checks of non-bank issuers) and M2 (M1 plus saving and small time

deposits and retail-type money marketmutual fund balances) have fluctuat-

ed widely in recent years, and theiraverage values over the last five to tenyears have been much different fromtheir long-run averages (Figure 2-1).For example, until the late 1980s, M2velocity had been relatively stable overlonger periods, while its short-run move-ments were positively correlated to inter-est rate changes In the early 1990s, how-ever, M2 velocity departed from its historical pattern anddrifted upward even as interest rates were declining

Some observers believe that ongoing, rapidfinancial changes will continue to cause instability in thefinancial linkages of the economy, undermining the use-fulness of money and credit aggregates as guides forpolicy Others expect the financial innovation process tosettle down, leading to a restoration, at least to some

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The Federal Reserve’s monetary policy actions have an immediate effect on the supply of or demand for reserves and the federal funds rate.

Understanding Open Market Operations / 5

extent, of the usefulness of money and credit as policyguides Whatever the future outcome of these controver-sies, the Federal Reserve has been obliged, for sometime now, to reduce its reliance on numerical targets formoney and credit in formulating monetary policy Inrecent years, the FOMC has used a wide range of finan-cial and nonfinancial indicators in judging economictrends and the appropriateness of monetary and finan-cial conditions, and in making monetary policy plans Ineffect, under this eclectic approach, the FOMC’s strate-

gy for changing bank reserve levels aims at inducingbroad financial conditions that it believes to be consistentwith final policy goals

In making monetary policy plans, the FederalReserve and the FOMC are involved in a complex,dynamic process in which monetary policy is only one ofmany forces affecting employment, output and prices.The government’s budgetary policies influence the econ-omy through changes in tax and spending programs.Shifts in business and consumer confidence and a vari-ety of other market forces also affect saving and spend-ing plans of businesses and households Changes inexpectations about economic prospects and policies,through their effects on interest rates and financial con-ditions, can have significant influence on the outcomesfor jobs, output and prices Natural disasters and com-modity price shocks can cause significant disruptions inoutput supply and the economy Shifts in international

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996

M1 Velocity and 3-Month Treasury Bill Rate

Monetary Velocities and Interest Rates

Notes: (1) Quarterly observations.

(2) Velocities are ratios of nominal GDP to M1 or M2.

(3) M2 opportunity cost is the difference between the 3-month Treasury

bill rate and the average rate paid on M2 components.

Figure 2-1

M2 Velocity and M2 Opportunity Cost

3-Month Treasury (Right Scale)

M1 Velocity (Left Scale)

7.6

Average M2 Velocity

1960-95

Average M2 Velocity 1986-95 Average M2 Velocity

1980-89

M2 Opportunity Cost (Right Scale)

trade rules and regulations and in economic policies

abroad can lower or raise the contribution of the

exter-nal sector to the U.S economy

The FOMC also must estimate when, and to

what extent, its own policy actions will affect money,

credit, interest rates, business developments and prices

Since the state of knowledge about the way the

econo-my works is quite imperfect, policymakers’

understand-ing of the effects of various influences, includunderstand-ing the

effect of monetary policy, is far from certain Moreover,

the working of the economy changes over time, leading

to changes in its response to policy and nonpolicy

fac-tors On top of all these difficulties, policymakers do not

have up-to-the-minute, reliable information about the

economy, because of lags in the collection and

publica-tion of data Even preliminary published data are

fre-quently subject to significant errors that become evident

in subsequent revisions

In all of this, there is no escape from forecasting

and from using judgment to deal with the uncertainties

of data and the policy process Indeed, monetary policy

formulation is not a simple technical matter; it is clearly

an art in that it greatly depends on experience, expertise

and judgment

Operational Approaches

Determining the appropriate reserve market

condi-tions—that is, the desired degree of monetary policy

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restraint—also is very complicated In choosing an ating strategy, the FOMC attempts to achieve a desireddegree of monetary policy restraint, ease or tightness, byfocusing on the reserve supply relative to demand, andthe associated level of the federal funds rate TheDomestic Open Market Desk at the Federal ReserveBank of New York can come reasonably close to meet-ing short-term objectives for nonborrowed reserves—supply of reserves excluding discount window borrow-ing The contemplated reserve levels are based, ofcourse, on the FOMC’s desire to induce short-run mon-etary and financial conditions that will help to achievepolicy goals for the economy

oper-In principle, the FOMC can aim for direct control

of the quantity of reserves by not accommodatingobserved fluctuations in the demand for reserves.However, this will result in free movements in the federalfunds rate Alternatively, the FOMC can control the fed-eral funds rate by adjusting the supply of reserves tomeet all changes in the demand for reserves; this willallow the quantity of reserves to vary freely Over theyears, the actual approach has been adapted to chang-ing circumstances Sometimes the emphasis has been

on controlling the quantity of reserves; other times, thefederal funds rate

While the FOMC generally has not aimed at cise control of the quantity of reserves, the operatingstrategy from October 1979 to late 1982 was closely

pre-consistent with this approach Concerned over rapidly

accelerating inflation in the late 1970s, the Committee

sought changes in its operating procedures in order to

control money stock growth more effectively In October

1979, the Committee began targeting nonborrowed

reserves, allowing the federal funds rate to fluctuate

freely within a wide and flexible range Under this

approach, the targeted path for nonborrowed reserves

was based on the FOMC’s growth objectives

for M1—currency, checkable deposits

and travelers checks of nonbank issuers

M1 growth in excess of the Committee’s

objectives would cause the depository

institutions’ demand for reserves to

out-strip the nonborrowed reserves target,

putting upward pressures on the funds

rate and other short-term rates The rise

in interest rates, in turn, would reduce

the growth in checkable deposits and

other low-yielding instruments, bringing money stock

growth back toward the Committee’s objectives

The reserve targeting procedure from 1979 to

1982 gradually came to provide assurance to financial

markets and the public at large that the Federal Reserve

would not underwrite a continuation of high and

acceler-ating inflation Reinforcing this procedure’s built-in effects

on money market conditions were judgmental changes

in nonborrowed reserve objectives and in the discount

rate Monetary policy contributed importantly to loweringthe inflation rate sharply, albeit not without a significantincrease in interest rate volatility and a period of markeddecline in output

The historical relationship between M1 and theeconomy broke down in the early 1980s, leading theFOMC to de-emphasize its control of M1 during 1982 Inlate 1982, the Committee abandoned the formal reservetargeting procedure and moved toward accommodating

short-run fluctuations in the demand forreserves, while limiting their effects

on the federal funds rate.Subsequently, ongoing deregulationand financial innovation precluded areturn to the use of numerical objec-tives for M1 and the nonborrowedreserve targeting procedure

As a consequence, since 1982,the Federal Reserve’s operating proce-dures have focused on achieving a particu-lar degree of tightness or ease in reserve market condi-tions rather than on the quantity of reserves Specifically,the FOMC expresses its operating directives in terms of

a desired degree of reserve pressure—that is, the costsand other conditions for the availability of reserves to thebanking system—which is associated with an averagelevel of the federal funds rate The approach for evaluat-ing the degree of reserve pressure, however, has

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Monetary policy formulation is not a simple technical matter;

it is clearly an art in that it greatly depends

on experience, expertise and judgment.

changed over time As discussed in detail in Chapter 5,

discount window borrowing targets were used as the

main factor for assessing reserve availability conditions

during 1983-87, but they have not played a significant

role through much of the subsequent period

Under the current approach, the FOMC uses the

federal funds rate as the principal guide for evaluating

reserve availability conditions and indicates a desired

level of the federal funds rate This judgmental approach

involves estimating the demand for and supply of

reserves, and accommodating all significant changes in

the demand for reserves through adjustments in the

sup-ply of nonborrowed reserves It allows for only modest

day-to-day variations in the funds rate around the level

intended by the Committee

Financial Markets

The money market—which includes the federal funds

market—provides the natural point of contact between

the Federal Reserve and the financial system The money

market is a term used for wholesale markets in

short-term credit or IOUs, comprising debt instruments

matur-ing within one year The market is international in scope

and helps in economizing on the use of cash or money

Borrowers who are the issuers of short-term

IOUs—gen-erally, the U.S Treasury, banks, business corporations

and finance companies—can bridge differences in the

timing of receipts and payments or can defer long-term

borrowing to a more propitious time The market allowsthe lenders—businesses, households or governmentalunits—to offset uneven flows of funds by allowing them

to invest in short-term interest-earning assets that can

be readily converted into cash with little risk of loss Theycan also time their purchases of bonds and stocks totheir particular views of long-term interest rates andstock prices

The main instruments of the money market arefederal funds, Treasury bills, repurchase agreements(RPs), Eurodollar deposits, certificates of deposits (CDs),bankers acceptances, commercial paper, municipalnotes and federal agency short-term securities (seeFigure 2-2 for definitions of instruments) The stock-in-trade of the market includes a large portion of the U.S.Treasury debt and federal agency securities The dailydollar volume in this market is very large, several timesthat of the most active trading days on the New YorkStock Exchange

Banks are at the center of the money market,with their customer deposits and their own reserve bal-ances at the Federal Reserve serving as the core ele-ment in the flow of funds Large banks borrow and lendhuge sums of money, on a daily basis, through the fed-eral funds market They are also particularly active in themarkets for RPs, Eurodollars and bankers acceptances.Many banks act as dealers in money market securities,while many others offer short-term investment services

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Like other financial institutions, banks invest in

short-term instruments such as Treasury bills and commercial

paper Banks also supply much of the short-term credit

that allows nonbank dealers in money market paper to

buy and hold an inventory

Changes in borrowing and lending in the money

market are reflected more or less continuously in the

demand for nonborrowed reserves relative to the

avail-able supply, with immediate consequences for the

feder-al funds rate Thus, if the Federfeder-al Reserve increases the

reserve supply relative to demand—i.e eases reserve

market conditions—the funds rate will fall quickly, and

vice versa Sustained movements of the federal fundsrate are transmitted almost fully to yields on Treasurybills, commercial paper and other money market instru-ments

The transmission of monetary policy actions tocapital markets—markets for Government securities andcorporate bonds and stocks with maturities exceedingone year—and the foreign exchange market is morecomplex and less predictable Insurance companies,pension funds and other investors in capital marketinstruments seek rates of return that will compensatethem, not only for expected future inflation, but also for

Non-interest-bearing deposits held by banks and other

depository institutions at the Federal Reserve; these are

immediately available funds that institutions borrow or lend,

usually on an overnight basis.

Treasury Bills

Short-term debt obligations of the U.S Treasury that are

issued to mature in 3 to 12 months.

Repurchase Agreements

Short-term loans—normally for less than two weeks and

frequently for one day—arranged by selling securities to

an investor with an agreement to repurchase them at a

fixed price on a fixed date.

Eurodollar Deposits

Dollar deposits in a U.S bank branch or a foreign bank

located outside the United States.

An unsecured promissory note with a fixed maturity of one

to 270 days; usually it is sold at a discount from face value.Municipal Notes

Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

Federal Agency Short-Term SecuritiesShort-term securities issued by federally sponsored agencies such as the Farm Credit System, the Federal Home Loan Bank and the Federal National Mortgage Association

10 / Understanding Open Market Operations

uncertainty and forgone real return In making

invest-ment decisions, such investors take into account recent

experience with inflation and inflation expectations, as

well as numerous other factors, including the federal

budget deficit, long-term prospects for the economy,

expectations about short-term interest rates and the

credibility of monetary policy These same

considera-tions are also important in the transmission of monetary

policy to the foreign exchange market

Given the wide variety of influences on capital

markets, long-term interest rates do not respond

one-for-one to changes in the federal funds rate In general,

sustained changes in the federal funds rate (and other

money market rates) lead to significant, but usually

smaller, changes in long rates Such interest rate

changes also may tend to strengthen or weaken the

dol-lar against other currencies, other things remaining the

same For example, a rise in U.S interest rates relative to

interest rates abroad will tend to make dollar assets

more attractive to hold, increasing the foreign exchange

value of the dollar as long as U.S inflation trends and

other forces are not working to offset the upward

pres-sures on the dollar

Economic Effects of Monetary Policy

By causing changes in interest rates, financial markets

and the dollar exchange rate, monetary policy actions

have important effects on output, employment and prices

These effects work through many different channels,affecting demand and economic activity in various sectors

of the economy Figure 2-3 shows the main contours ofthe transmission of monetary policy to the economy (seeBox for a brief description of the transmission channels)

Private Spending and Output

Changes in the cost and availability of credit, reflectingchanges in interest rates and credit supply conditions,are the most important sources of monetary policyeffects on the economy Higher interest rates tend toreduce demand and output in interest-sensitive sectors:higher corporate bond rates increase borrowing costs,restraining the demand for additional plant and equip-ment; higher mortgage rates depress the demand forhousing; higher auto and consumer loan rates reducepurchases of cars and other consumer durables Other(non-rate) restrictive provisions of loan agreements andlower supplies of credit also restrain the demand forinvestment goods and consumer durables, especially bythose businesses and households particularly depen-dent on bank credit

Consumption demand also is affected bychanges in the value of household assets such as stocksand bonds In general, asset values are inversely related

to movements of interest rates—higher interest ratestend to reduce the value of household assets, otherthings remaining the same

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Understanding Open Market Operations / 11

Figure 2-3 indicates that monetary policy

actions influence output, employment and prices

through a number of complex channels These

chan-nels involve a variety of forces in financial markets that

cause changes in (1) the cost and availability of funds

to businesses and households, (2) the value of

house-hold assets or net worth, and (3) the foreign exchange

value of the dollar with direct consequences for

import/export prices All these changes, in due course,

affect economic activity and prices in various sectors of

the economy

When the Federal Reserve tightens monetary

policy— for example, by draining bank reserves through

open market sales of Government securities—the

fed-eral funds rate and other short-term interest rates rise

more or less immediately, reflecting the reduced supply

of bank reserves in the market Sustained increases in

short-term interest rates lead to lower growth of

deposits and money as well as higher long-term

inter-est rates Higher interinter-est rates raise the cost of funds,

and, over time, have adverse consequences for

busi-ness investment demand, home buying and consumer

spending on durable goods, other things remaining the

same This is the conventional money or interest rate

channel of monetary policy influence on the economy

A firming of monetary policy also may reduce

the supply of bank loans through higher funding costs

for banks or through increases in the perceived

riski-ness of bank loans Similarly, non-bank sources ofcredit to the private sector may become more scarcebecause of higher lending risks (actual or perceived)associated with tighter monetary conditions Thereduced availability—as distinct from costs—of loansmay have negative effects on aggregate demand andoutput This is the so-called “credit channel” that mayoperate alongside the interest rate channel

Higher interest rates and lower monetarygrowth also may influence economic activity throughthe “wealth channel” by lowering actual or expectedasset values For example, rising interest rates general-

ly tend to lower bond and stock prices, reducing hold net worth and weakening business balancesheets As a consequence, business and householdspending may suffer

house-Finally, a monetary policy tightening affectseconomic activity by raising the foreign exchange value

of the dollar—the exchange rate channel By makingU.S imports cheaper and by increasing the cost of U.S.exports to foreigners, the appreciation of the dollarreduces the demand for U.S goods, and, therefore,has adverse consequences for the trade balance andoutput On the positive side, lower import prices help inimproving the U.S inflation performance

Needless to say, all these effects work in theopposite direction when the Federal Reserve easesmonetary policy

Monetary Policy Influence on the Economy

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The outlook for the economy and expectations

of households and businesses play a central role in themagnitude and timing of monetary policy effects on theeconomy Households’ own experience with the cyclicalrise and fall in interest rates may affect their actions Asustained sharp rise in interest rates, for example, maysuggest more uncertain prospects for employment andincomes, resulting in greater household caution towardspending on consumer goods and house purchases.Conversely, a significant fall in interest rates during a peri-

od of weak economic activity may encourage greaterconsumer spending by increasing the value of householdassets Lower mortgage rates, together with greateravailability of mortgage credit, also may stimulate thedemand for housing

Businesses plan their inventories and additions toproductive capacity (i.e capital spending) to meet futurecustomer demands and their own sales expectations.Since internal resources—retained earnings and deprecia-tion allowances—do not provide all of their cash require-ments, businesses often are obliged to use the credit mar-kets to finance capital spending and inventories

During business cycle expansion, the businesssector’s need for external financing rises rapidly, as firmsaccumulate inventories to ensure that sales will not belost because of shortages At the same time, businessesattempt to finance additions to capacity Greater busi-ness demand for funds tends to bid up interest rates in

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The Transmission of Monetary Policy

Figure 2-3

Federal Open Market

Committee

Expectations of Inflation & Output

Consumption Spending

Import, Export Prices

Reserve Pressure, Federal Funds Rate

Interest Rates:

Short-term and Long-term

Supply of

Funds

Demand for Funds:

Federal Deficit and Business Investment

Credit Terms

and

Conditions

Deposits and Money

Bond and Stock Prices

Dollar Exchange Rates

Cost and Availability of Credit Household

Net Worth

Trade

Economy: Output, Employment, Income, Prices

financial markets, but higher rates do not pose serious

problems for businesses so long as sales are growing

and the economy is expanding at a rapid pace In this

environment, monetary policy tightening will dampen

capital spending and inventory building only slowly, if the

strong outlook for business sales and the economy

per-sists Eventually, however, higher interest costs and

reduced credit availability contribute to a

tem-pering of the optimistic outlook, leading

to weaker business sales, unwanted

accumulation of inventories and lower

output

With lower capital spending,

business credit demands fall during

peri-ods of business slowdown, putting

downward pressure on market interest

rates Actual and expected easing of

monetary policy work in the same

direc-tion, accelerating the speed of decline in rates and

increasing credit availability to businesses These

condi-tions gradually build up expectacondi-tions of stronger demand

and economic activity, setting the stage for an end to the

inventory runoff Eventually, production levels needed to

meet current sales are restored

Government Sector

Monetary policy has only a modest direct effect on

cap-ital spending by state and local governments Rising

interest rates tend to trim or postpone some state andlocal government capital spending projects, as privateinvestors bid away financial resources from other users.Conversely, a fall in interest rates tends to make somestate and local Government projects viable

In contrast, the discretionary spending and enue decisions of the federal Government are largelyimmune to monetary restraint or ease The U.S Treasury

rev-is, in fact, a major independent force

in financial markets, competing withother borrowers To some extent,federal credit demands tend to runcounter to private credit demands:they rise during recessions, when taxreceipts go down and cyclically inducedGovernment spendings go up; they fallduring expansions, reflecting favorableeffects on tax receipts and cyclicalGovernment spendings Since the early 1980s, however,federal credit demands have tended to remain very high,even in good times, because of a sharp rise in structuraldeficits Recent Government budget initiatives mayreverse this trend by reducing future structural deficits

External Sector

U.S monetary policy exercises significant effects on theeconomy through the external sector For example, theappreciation of the dollar associated with higher interest

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Monetary policy has significant effects on employment and output in the short run, but in the long run, it affects primarily prices.

rates reduces the demand for U.S goods by lowering

the cost of imports to Americans and increasing the cost

of U.S exports to foreigners With Americans

substitut-ing cheaper imports for domestically produced goods

and people abroad buying fewer American goods, U.S

production suffers and the trade balance worsens

Other countries have to weigh the benefits and

costs of changes in exchange rates resulting from U.S

monetary policy changes for their own economies A

country may welcome the stimulus from the depreciation

of its currency—the appreciation of the dollar—if its

economy is facing considerable slack and inflation is not

a serious problem On the other hand, if a country is

experiencing significant inflationary pressures at home, it

may attempt to offset the depreciation of its currency by

tightening monetary policy Of course, the feedback on

U.S exports and trade depends, not only on changes in

foreign and U.S monetary policies, but also on the pace

of economic growth here and abroad

Inflation

The drop in demand and output induced by tighter

mon-etary policy tends to relieve pressures on economic

resources Such relief is necessary to curb inflation in an

overheating economy By contrast, in a depressed

econ-omy, monetary ease helps increase employment of laborand other economic resources by generating higherdemand and output Monetary policy has significanteffects on employment and output in the short run, but

in the long run, it affects primarily prices To sustain inflationary economic growth over time, therefore, theFederal Reserve must aim at maintaining price stability orlow inflation Indeed, price stability is necessary, thoughnot sufficient, to maximize the long-run growth potential

non-of an economy

Monetary restraint or ease affects the economywith considerable time lags that differ among sectorsand, perhaps more importantly, between demand/outputand prices Normally, sales and production respond tomonetary policy changes more quickly than do wagesand prices The economy is characterized by many for-mal and informal contracts and other rigidities that limitchanges in prices and wages in the short run In addition,inflation expectations, which influence decisions to setwages and prices, tend to adjust rather slowly Over alonger period, however, monetary policy changes aretransmitted more fully to wages and prices as adjust-ment of inflation expectations is completed and con-tracts are renegotiated

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As background for understanding the monetary policy

implementation process, this chapter, first offers a brief

description of the institutional setting under which

depository institutions hold and manage their reserves It

then reviews a variety of influences on supply and

demand conditions for reserves The review emphasizes

the role of market factors in absorbing and supplying

reserves and its implications for open market operations

Depository Institutions’ Reserve Positions

All depository institutions in the United States, as in many

other countries, are subject to reserve requirements on

their customers’ deposits Commercial banks and thrift

institutions—mutual savings banks, savings and loan

associations and credit unions—whose checkable

deposits exceed a certain size are required to maintain

cash reserves equal to a specified fraction of those

deposits (Figure 3-1) As of end-1995, commercial banks

held about 86 percent of checkable deposits, and thrift

institutions the remaining 14 percent

The bulk of the commercial bank share of

checkable deposits is accounted for by member banks

of the Federal Reserve System About 4,000 commercialbanks were members of the System at the end of 1995.These included just over 2,900 federally charterednational banks—which are required to be members—and about 1,050 state-chartered banks Approximately6,000 state-chartered banks were not members at end-

1995 But they and all other depository institutions haveaccess to the Federal Reserve System’s lending facilities

on equal terms with members, just as they are subject toreserve requirements

Reserve requirements are structured to bearless heavily on smaller depository institutions At alldepository institutions, checkable deposits up to certainlevels—adjusted annually to reflect growth in the bankingsystem—either are exempted or carry relatively lowrequirements

Depository institutions hold required reserveseither as cash in their own vaults or as deposits at theirDistrict Federal Reserve Bank To provide banks andthrifts with flexibility in meeting their requirements, the

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Monetary Stresses and Reserve Management

Federal Reserve allows them to hold an average amount

of reserves over two-week reserve maintenance periods

ending on alternate Wednesdays, rather than a specific

amount on each day Large banks apply all of their vault

cash toward meeting requirements, since their required

reserves exceed their vault cash But many small banks

and thrift institutions hold more vault cash than their

required reserves because they need more cash to meet

customer demands than they do to meet reserve

requirements

In contrast, over 3,000 depository institutions inearly 1996 had less vault cash than their requiredreserves, obliging them to hold balances at ReserveBanks These so-called bound institutions accounted forroughly three-quarters of total checkable deposits

Coping With Reserve Pressures

In managing their reserve positions, depository tions attempt to balance two opposing considerations

institu-As profit-seeking enterprises, they try to keep theirreserves, which produce no income, close to therequired minimum Yet they also must avoid reserve defi-ciencies, which carry a penalty charge on the deficiency

at a rate that is 2 percentage points above the discountrate In addition, if a depository institution frequently fails

to meet requirements, its senior management is given awarning that continued failure would put the institutionunder scrutiny To clear their ongoing financial transac-tions through the Federal Reserve and to maintain acushion of funds in order to avoid penalty charges, manydepository institutions arrange with their Reserve Banks

to maintain supplementary accounts for required clearingbalances These additional balances effectively earninterest in the form of credits that can be used to pay forFederal Reserve services, such as check-clearing andwire transfers of funds and securities

Managing the reserve position of a depositoryinstitution is a difficult job The institution’s reserve posi-

of Deposits Reserve Ratio** Other Provisions

Depository institutions hold

Up to 0 percent an average amount of

$4.3 million reserves over a two-week

maintenance period; they are allowed to carry forward

$4.3 million for one maintenance period

to 3 percent any excess or deficiency of

$52 million up to four percent of their

requirements; reserve deficiencies beyond the Above 10 percent carry-forward amount are

to two percentage points above the discount rate.

* Time deposits and other bank liabilities are not subject to

reserve requirements at present.

** Fraction of deposits held as required reserves.

Understanding Open Market Operations / 17

tion is affected by virtually all of its transactions—whether

carried out for its customers or on its own account A

bank or thrift institution, for example, loses reserves when

it pays out cash or transfers funds by wire on behalf of its

customers Customer checks to pay out-of-town bills

funnel back through its Federal Reserve Bank and are

charged against its reserve or clearing account; customer

checks to pay in-town bills also drain reserves,

on a net basis, as accounts among banks

are settled A bank may also lose reserves

when it advances loans or buys securities

On the other hand, a bank gains reserves

from deposits of customer checks and

currency, sales of securities and numerous

other transactions At the end of each day,

after the close of wire transfers of funds

and securities, a bank’s reserve position

reflects the net of reserve losses and gains

resulting from all of its transactions

A depository institution facing a reserve

defi-ciency has several options It can try to borrow reserves

for one or more days from another depository institution

It can sell liquid, or readily marketable assets, such as

Government securities, pulling in funds from the buyer’s

bank It can bid for funds in the money market, such as

large certificates of deposits (CDs) or Eurodollars Using

Government securities or other acceptable collateral, a

depository institution also can—as a last resort—borrow

from its District Reserve Bank at the prevailing discountrate to compensate for unforeseen reserve losses

The Open Market Desk and Reserve Supply

While an individual institution can meet its reserve ages by purchasing or borrowing reserves from otherbanks or thrift institutions, depository institutions cannotexpand aggregate reserves (except by borrowing at the

short-discount window); they can merely passaround the existing reserves.Reserve shortages or surpluses ofdepository institutions are reflected

in the overall reserve supply anddemand in the federal funds market.When depository institutions, collec-tively, seek more reserves than areavailable in the market, they bid up thefederal funds rate As the funds raterises, more banks and thrift institutionsare induced to borrow at the discount window, bringingreserve supply back into line with reserve demand Thus,within a given reserve maintenance period, the bankingsystem as a whole has no practical alternative to bor-rowing more reserves from the Federal Reserve if aggre-gate reserve demand exceeds the total supply of non-borrowed reserves

Open market operations allow the Open MarketDesk at the Federal Reserve Bank of New York to adjust

A bank’s reserve position reflects the net

of reserve losses and gains resulting from all

of its transactions.

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the volume of nonborrowed reserves in the system

before depository institutions turn to borrowing from the

discount window Open market operations involve the

buying and selling of Government securities in the open,

or secondary, market by the Federal Reserve—a

pur-chase adds to nonborrowed reserves, while a sale

reduces them (see Chapter 5 for details) In this way, the

Federal Reserve can offset swings in reserves caused by

changes in the public’s demand for cash and numerous

other factors, sheltering the funds rate from the effects of

potential reserve changes Alternately, the Federal

Reserve can choose not to offset, or even to reinforce,

movements in nonborrowed reserves, inducing changes

in the funds rate

By managing the supply of nonborrowed

reserves in relation to the demand for them, the Federal

Reserve can adjust the cost and availability of reserves

to induce changes in the federal funds rate When the

Open Market Desk adds more reserves than depository

institutions collectively demand, the funds rate declines

Over time, higher reserves and a lower federal funds rate

stimulate the expansion of money and credit in the

econ-omy, other things remaining the same Conversely, when

the Desk holds back on reserves relative to demand, the

funds rate rises and the growth of money and credit

tends to go down

While open market operations allow the Federal

Reserve to exert control over the supply of nonborrowed

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reserves, many factors outside the Federal Reserve’scontrol influence that supply Among the most importantsuch factors are changes in currency holdings of thepublic, the Treasury’s cash balances at the FederalReserve, short-term credit to banks resulting from theFederal Reserve’s national check clearing arrangementsand foreign central bank transactions As discussed inChapter 5, the Federal Reserve forecasts daily these andother factors affecting reserves to assess the need foropen market operations Here, we briefly sketch thegeneral implications of these factors for reserve move-ments and open market operations

Currency in Circulation

Depository institutions obtain currency from the FederalReserve Banks to replenish actual or anticipated cashwithdrawals by customers, and they pay for it throughdebits of their reserve accounts at the Fed Over time,currency demand is the largest single factor requiringreserve injections, because it has a strong growth trendwhich reflects, primarily, the growth trend of the econ-omy However, currency movements display significantshort-run variations Such variations may result frommany sources, including cyclical developments in theeconomy or changes in foreign demand for U.S cur-rency, which usually expands in times of political andeconomic uncertainty abroad Indeed, in recent years,foreign demand for U.S dollars, especially from high-

inflation economies of Eastern Europe and other regions,

has contributed significantly to the growth of U.S

cur-rency in circulation

Normally, seasonal swings in the public’s

rency holdings are the dominant source of short-run

cur-rency variations Some of these swings represent

intra-monthly patterns reflecting such routine transactions as

payments of salaries and social security benefits Others

result from the effects of somewhat longer seasonal

cycles on business activity during the year For example,

currency in circulation rises substantially during the

win-ter holiday shopping season, from early November to

year-end, and much of this bulge reverses in the

follow-ing month (Figure 3-2)

Most short-term variations in currency

move-ments are reasonably predictable, since they follow

recurrent seasonal patterns (Figure 3-3) The Federal

Reserve, through its open market operations, attempts

to offset recurrent contractions and expansions in

reserves associated with seasonal swings in currency If

the Federal Reserve did not do so, depository institutions

as a group would be obliged to adjust their reserve

posi-tions by lowering or raising their investments and

short-term loans Such actions would cause significant

fluctu-ations in the federal funds rate and other short rates, and

could lead to serious market disturbances Indeed, one

of the original reasons for creating the Federal Reserve

System was to avoid the undesirable effects of seasonal

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Figure 3-2

Changes in Currency Demand:

Winter Holiday Shopping Season*

Billions of dollars

* For each period, the first bar represents the cummulative increase over the seven-week period from mid-November to the beginning of January, while the second bar reports the cummulative decrease over the four-week period from early January to end-January.

-14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14

swings in the public’s currency holdings Before the

establishment of the Federal Reserve in 1913, financial

strains from seasonal increases in currency demands

were quite common and became so severe on a few

occasions that they touched off financial panics, causing

bankruptcies and recessions in business activity

Treasury Balances

The U.S Treasury maintains its working balances at the

Federal Reserve for making and receiving

pay-ments; increases in these balances absorb

reserves since they involve the transfer of

funds from the public and depository

insti-tutions to the Federal Reserve, while

decreases in these balances supply

reserves to banks and thrifts The Treasury

attempts to keep its balances reasonably

stable, generally around $5 billion, so as

not to complicate the Fed’s job of

man-aging reserves It places additional cash in

Treasury tax and loan note option (TT&L) accounts at

depository institutions that have agreed to accept them;

these accounts serve as collection points for tax

receipts Each depository institution limits the amount of

TT&L account balances because it must pay interest on

those balances and must hold collateral against them

When balances exceed the limit, the excess is

trans-ferred to the Federal Reserve

The Treasury can transfer funds into or out of theTT&L accounts on a daily basis to keep its FederalReserve balances close to the target level It can make a

“call” before 11 a.m on the larger depository institutions

to transfer funds to the Fed on the same day, or the lowing day It can make a “direct investment” to movefunds from the Fed to the TT&L accounts

fol-Because of the difficulties in predicting the ing and size of the myriad receipts and expenditures ofthe federal Government, daily estimates of Treasury bal-

tim-ances at the Fed are subject to sizableerrors It is not unusual for the bal-ance to be $1 billion or so higher orlower than expected Most of thetime such errors have only a modesteffect on the average level of reservesover the two-week maintenanceperiod, since the Treasury can takeaction the next day to bring the balanceback to the desired level

However, a more serious reserve agement problem arises when Treasury tax receipts areparticularly heavy—for example, following some of themajor tax dates in January, April, June and September(Figure 3-4) In this case, Treasury balances accumulate

man-in excess of the combman-ined aggregate limits on the TT&Laccounts set by depository institutions, lifting balances atthe Federal Reserve and draining reserves from the

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One of the original reasons for creating the Federal Reserve System was to avoid the undesirable effects

of seasonal swings in the public’s currency holdings.

banking system At times, the excess in Treasury

bal-ances may last for up to two weeks before they drop

below the aggregate capacity of the TT&L accounts

Accordingly, on those occasions, the Open Market Desk

has to offset reserve drains by injecting large amounts of

reserves

Federal Reserve Float

Households and businesses make a significant portion of

their payments by writing checks on their accounts at

depository institutions The Federal Reserve’s national

check clearing system facilitates the movement of these

checks around the country The Reserve Banks credit a

bank’s reserve account at the Fed for checks

deposited—presented for collection—by the bank anddebit its account for checks drawn on it and presented

by other banks When a presenting bank’s reserveaccount is credited before a corresponding debit ismade to the account of the bank on which the check isdrawn, two banks have credit simultaneously for thesame reserves, creating reserve float This float arisesbecause Reserve Banks credit checks presented for col-lection, under a preset schedule, to a bank’s reserveaccount within a maximum of two business days, while itsometimes takes more than two days to process thosechecks and collect funds from the banks on which theyare drawn

Since 1983, the Fed has actively discouragedfloat by charging the banks explicitly for the float theyreceive As a result, float has declined dramatically inrecent years Float also has become more predictablebecause of increased information flows about deliveryand processing of checks Most of the time, therefore,changes in float are not a significant consideration foropen market operations

Still, however, float can vary widely on a weekly oreven monthly basis (Figure 3-5), and occasionally, it showslarge increases when normal check delivery is interrupted,for example, due to bad weather On these occasions, theOpen Market Desk may be obliged to engage in significantoperations to offset the effects of large swings in float onthe supply of nonborrowed reserves

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Treasury Balances at the Fed

Foreign Central Bank Transactions

Many foreign central banks and official international

insti-tutions maintain working and short-term investment

bal-ances at the Federal Reserve to execute their

dollar-denominated transactions Drawing down of these

bal-ances increases the reserves of depository institutions

receiving payments Moving funds from depository

insti-tutions into these balances drains reserves of the

bank-ing system At times, unexpected transfers into and out

of foreign central bank accounts can result in significant

increases or decreases in reserves, requiring sizable

off-setting open market operations

Deposit Flows and Reserve Demand

Open market operations are required, not only to offsetseasonal and other short-lived influences on the supply

of nonborrowed reserves, but also to deal with changes

in depository institutions’ demand for reserves.Specifically, in managing the supply of nonborrowedreserves, the Open Market Desk must make adjustmentsfor changes in the demand for those reserves so as tocreate money market conditions that are consistent withthe desired monetary policy objectives Open marketoperations, therefore, have both defensive and dynamicaspects

Depository institutions’ demand for reserves hastwo components: required reserves and excess reservesabove requirements Since banks and thrifts attempt tokeep their reserves—which yield no income—close tothe required minimum, aggregate excess reserves in thesystem are quite small In 1995, for example, excessreserves averaged only about $1 billion, less than 2 per-cent of total reserves

Required reserves are based on checkabledeposits, which serve as the principal means of paymentfor transactions in the economy Over time, the public’sdemand for checkable deposits is related to the growth

of the economy and developments in other modes ofpayments—such as cash, direct debit of accounts andelectronic transfers—that may encourage or discouragethe use of checks for making payments But, in the short

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Weekly and Monthly Average Float,

run, the demand for checkable deposits can be highly

variable, leading to large increases or decreases in

required reserves

Short-run variability of checkable deposits

results in part from the influence of cyclical and other

short-term developments in business activity; these

developments go hand-in-hand with short-run changes

in interest rates and affect credit flows and the holdings

of various income-producing assets—such as

bonds, stocks and time/saving deposits—

relative to currency and demand deposits

that yield no income But it also reflects a

variety of recurring influences, including

tax payment cycles, regular payroll

dis-bursements and seasonal movements in

demands for credit and deposits For

example, businesses and households

normally keep checkable deposits at

minimum levels because such deposits

pay low interest rates, if any at all However, they shift out

of higher-yielding short-term investments into checkable

deposits when tax, payroll or other significant payments

are due Around major tax payment dates, for instance,

checkable deposits at banks and thrifts increase

sub-stantially, enabling businesses and households to make

their tax payments to the U.S Treasury Required

reserves increase correspondingly on a temporary basis,

and decline a few days later when the funds are

trans-ferred to the TT&L balances, which are not subject toreserve requirements

Bank Decisions and Monetary Policy

Seasonal adjustments and related procedures can beapplied to sort out recurrent patterns of deposit move-ments But whether short-term monetary developmentsare consistent with the Federal Reserve’s expectationsand policy goals also will depend on how the underlying

deposit flows and the correspondingreserve demands evolve inresponse to ongoing economic andfinancial trends in the economy Theactual behavior of deposits and credit

in the economy reflects the interaction

of depository institutions, their tomers—businesses and households—and the Federal Reserve The lendingand funding decisions of banks andthrifts are influenced by current andprospective customer demands, the outlook for theeconomy and perceptions about monetary policy Withinthis context, lenders must assess the loan demand theyare likely to face and possible growth of their owndeposits

cus-For example, if a bank is facing rising loandemand at a time when the outlook for economic growth

is strong, it may expect the Federal Reserve to tighten

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In the short run, the demand for checkable deposits can be highly variable, leading to large increases or decreases in required

reserves.

monetary policy, putting upward pressures on interest

rates In that case, if the bank’s own deposit growth is

insufficient to meet its loan demand, it may fund loan

demand by issuing domestic CDs or by borrowing in the

Eurodollar market at prevailing interest rates, rather than

risk having to roll over overnight borrowings at higher

rates On the other hand, if the bank expects its own

deposit growth to outrun its loan demand, it may attempt

to lend more to creditworthy customers, while buying

additional securities A turn in the outlook toward a

slug-gish economy would accelerate such activities

Bank decisions affect money and credit

condi-tions, as do developments in numerous other financial

and nonfinancial indicators The Federal Open Market

Committee (FOMC), as described in the next chapter,

considers all these indicators in determining the course

of monetary policy and in assessing the need for

changes in it The Domestic Open Market Desk at the

Federal Reserve Bank of New York, which is responsiblefor implementing the FOMC’s decisions on a day-to-daybasis, focuses on achieving and maintaining the FOMC’sdesired degree of reserve pressure and the associatedfederal funds rate (see Chapter 5 for details) TheManager of the Desk and Federal Reserve staffs in NewYork and at the Board of Governors in Washington, D.C.,track reserve supply and demand conditions at banksand thrift institutions, movements of various short andlong interest rates and deposit flows into and out of M1and broader monetary aggregates They also watchclosely the responses of financial and foreign exchangemarkets to developments in monetary policy, inflationexpectations and the economy more generally All thisinformation helps in assessing whether money and finan-cial conditions in the economy are developing in line withthose contemplated by the FOMC

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